What’s Next For Inflation, Supply Chain, & The Consumer

Image of a shipping storage container off the water, representing global supply chain.
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Cowen’s Retail and Consumer Brands analyst John Kernan is joined by Shipping Expert John McCown, Founder and President of the Sourcing Journal, Ed Hertzman, and Jason Seidl, Cowen’s Transport analyst, to discuss their perspective on the supply chain. Topics include the outlook for container shipping, freight costs into 2023, inventory levels across retail, geopolitical risks, and ESG policy within the global supply chain. The discussion is moderated by Head of Thematic Content, Bill Bird.

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Transcript

Speaker 1:

Welcome to Cowen Insights, a space that brings leading thinkers together to share insights and ideas shaping the world around us. Join us as we converse with the top minds who are influencing our global sectors.

John Kernan:

I’m John Kernan, Cowen’s retail and consumer brands analyst. I’m excited to be joined today by three thought leaders in the supply chain, including Ed Hertzman, president and founder of the Sourcing Journal, Jason Seidl, Cowen’s Transport Analyst, and John McCown, a longtime executive in the shipping and container industry. This conversation will be moderated by Bill Bird, Cowen’s head of thematic content.

Bill Bird:

Thanks John. We have a great topic and a distinguished panel, so let’s dive right into it. John Kernan, let’s start at a high level. What’s your outlook for the supply chain and the flow of inventory across the retail ecosystem?

John Kernan:

Bill, we see inventory levels on a cost and unit basis that are higher than we’ve ever seen in the sector’s history. This is, at the same time, demand is likely to slow as the Fed raises interest rates into next year, and the Fed funds rate settles around four and a half to 4.75%. It’s a level we haven’t seen since before the great financial crisis. Monetary policy is going to raise supply chain finance costs, and as you saw with FedEx’s historic guidance reduction, demand for shipping products is declining obviously at a rapid rate. We’re in uncharted territory from a cost and unit perspective, as inventory that’s capitalized on everyone’s balance sheets was sourced at a much higher cost in her early 2022.

That’s when container prices, freight and raw materials prices were much higher. Encouragingly we’re seeing deflation in container costs and some freight rates here in the US. Our guests, John McCown and Cowen transport analyst Jason Seidl will have greater insight into those costs and we are hopeful that lower levels of air freight could support some gross margin recovery over time. Given the lead times we saw on ocean freight last year, companies had to resort to expensive air freight to get product to consumers on time.

Bill Bird:

Jason, would love to get your perspective, specifically on US trucking and rails. What’s your freight cost outlook as we head into the holidays this year and for the start of 2023, and are your companies seeing signs of demand moderation?

Jason Seidl:

Sure. So let’s start with the last part of your question first. There’s clearly been demand moderation throughout the freight network. It really started, I’d say, in that late May timeframe that we started to see, moreso on the consumer side we’ve started to see it bleed a little bit in the industrial side. So there’s definitely a slowdown, and even in the past couple weeks, as I talked to one of my contacts throughout the supply chain. What I will say in terms of the rates, it’s interesting now because I’ve been in trucking and logistics for about 30 years now. This cycle’s different because we have inflation behind it like we’ve never seen before. So carrier [inaudible 00:03:04] added with the fact that all their other costs are rising. Whether you’re looking at hiring cost of a driver or you’re looking at the cost of a class eight vehicle or you’re looking at sticking tires on or replacement parts, everything’s more expensive for them.

In the past I would tell you that undoubtedly with a decline we would see declining contract rates on the truckload side and we still may, but I think it’s going to be a little bit tougher to get there. I think the economy’s going to have to push lower to see negative contract rates in 2023. Are we going to see lower increases in rates? Absolutely. Gone are the 10 to 15% rate increases that we see from truckload carriers. I think we’re going to see very low single digits, and if the economy pushes really lower below that. Now on the rail side, rails have had pricing power since the back half of 2003, and they’re essentially regional duopolies and in many cases, depending upon where they’re going into, their monopolies. So they will always have pricing power. The question is how much pricing power they will have. The thing that’s new on the rail side is they just agreed to the largest labor contract in their history in terms of price increases for labor, they’re going to have to try to recoup that over time,, because most rail contracts on average are about three years long.

So the rails are going to be faced with the difficult task of trying to raise prices into a declining demand environment. And when you look at the competitiveness of modes, they tend to compete more with the tracking side on the intermodal or some of the merchandise lanes that they have out east. So when you look at spot rates for trucking for example, we are declining every week that we look at the index, and I expect weakness from here for the remainder of the year on the spot side. I think we’re going to find a bottom sometime in 23 with that, and we’ll see where we can go after that. But right now it’s a good sign for shippers. So for a lot of John’s companies, I think they’re a much better position now than they were before. I will say though, when I look at my podcast colleague John’s commentary on the ocean rate, it’s extremely interesting to me.

The one thing I think we have to tell shippers is to be on the lookout. As you change ports of entry, which is happening, right? We’ve seen a shift from the west coast to the east coast. There’s different stresses in the supply chain. So now we’re seeing Savannah start to back up. But beyond the stresses that you’re seeing on the delays, you’re going to be stressing the drayage capacity at these other ports. So while your rate may have gone down from the $20,000 spot rate that we saw over the last 12 months to maybe only $4,000, your drayage cost might go up from 250 to 400 because you can’t find trucks. So in terms of your total landed cost, you’re going to have to factor stuff like that in.

Bill Bird:

Jason, what about further port disruption? You talked a bit about some of the bottlenecks in different ports as goods move around, do you expect any further disruption in key ports in the US?

Jason Seidl:

I don’t think anything along the lines of what we saw over the last 24 months. Again, as people shift their landed areas of the ports, you’re going to see some disruption. But right now, I honestly think a slow down is your best friend, if you will. Obviously if there’s a labor issue at the port that could change things, but we’ll have to go from there. The ports that I’m keeping a close eye on for the next couple years, in terms of getting some shifts from the west coast, I think you want to look at Savannah, I think you want to look at New York, New Jersey, you want to look at Houston, Canadian National’s really pushing Halifax.

If you want to shift at the west coast, you could also look at Vancouver, the Port of Prince Rupert. And if the CP KSU deal goes through in the first quarter, with approval from the service transportation board, I think there’s going to be an interesting dynamic as shippers start looking at the Port of Lázaro Cárdenas to take freight from the west coast of Mexico up into Chicago because they’re getting about six days of service on the rail side fairly consistently in some of the test runs.

Bill Bird:

Jason, you’ve developed several interesting proprietary freight indices that shed light on the economy. What do they tell you now about the macro environment here in the US?

Jason Seidl:

Sure. So as I mentioned before, our spot rate, which comes out weekly with FMIC is just showing declining rates every single week. And that’s really a function of supply demand, because the trucking market is wildly fragmented, full of mom or pops, they all play in the spot market, where the larger carriers predominantly play in the contract market. What we saw over, say, the last 18 months is there was about 180,000 net carriers that were added to the network. Right? What we’re starting to see is those carriers that were added are slowly coming out of the network. Now the reasons for this is, again, most of these are either owner operators or what I would call micro carriers. They live in the spot market. They came in when your class eight costs were extremely high, whether you were buying or leasing, and spot rates were just fantastic.

They thought that was going to live forever. Guess what? It didn’t. Spot rates are collapsing, diesel went up, and even with a decline in diesel, it’s still higher on a year over year basis and these guys are just eating the cost. So what we’ve seen over the last, let’s call it, 20 weeks, is net declines, not enough to offset that total 180,000, but we’re probably net down 40,000 over the last couple, let’s call it, 20 weeks. So net net we’re still up 140, but we’re heading in the right direction in terms of taking capacity out of the marketplace to find that equilibrium between supply and demand and trucking. So we still expect between now and the end of the year to be negative on the spot side, and I think sometime next year, like I said before, we find that bottom.

On the contractual side of things, we’re still showing positive rate environment, whether you are an LTL carrier or a TL carrier or rail, I think that will continue. I don’t see rail or LTL ever going negative no matter what the economy does. I think truckload, like I said before, it will depend. When you’re looking on the parcel side, I think the parcel prices, if you looked at the last AFS Cowen logistics predictive freight showing increased prices that we published before. That was sort of reinforced by some of the announcements by FedEx and UPS in terms of the GRIs that are putting forward some of the largest GRIS we’ve seen. So that’s really a surprise.

These guys are going to try to offset declining volumes with increasing, especially as we enter the holiday season. Now one thing to remember, that’s very difficult to try to calculate from an investor standpoint, is last year we had a lot of big ancillary charges being tacked on to a lot of shipments, and it’s very hard to sparse out whether last year’s big total, let’s say, a cost per shipment if you will, on a truckload side. How much of that was special one time charges that they hit that may or may not be reoccurring this year. And that’s going to be the thing that I think is going to be coming down, and it’s going to be interesting to see that in the results when they’re reported for four Q in January.

Bill Bird:

Eddie, can you talk about what you’re seeing in orders at the factory level and how this informs your outlook for consumer spending in 2023?

Eddie Hertzman:

Certainly. So regardless of who I speak to both at the factory level or whether it be an agency or trading company, I would say on average they’re seeing Q1 port bookings down anywhere from 20, 30% on average across categories. I think if you speak to people in the home market, it’s even more intense. I think there’s a couple things to consider. One, as much as we like to think that we’re going to move through a lot of the inventory that came in the first six months of this year, there’s still going to be some pack and hold, which is why there’s a reduction in bookings into next year. Two, John and I, we were having this conversation last week, I was looking at the [inaudible 00:11:07] data through January through June of this year, we imported 24% more units of apparel into this country, which, due to inflation, accounts to about 40% more dollars wise of value.

So in such a mature economy like the United States, how are we going to absorb that much inventory after having the best year ever in 2021? So a rationalization and a right sizing inventory levels is not only, it’s very much necessary and I think that’s being reflected in the order bookings next year. I also think people have to be a little bit more conservative as the cost of money is becoming more expensive and the cost of bringing these goods in are starting to wear on them. And one of the things I’m hearing from the lending community, and this may not impact some of the larger publicly traded companies, but some of the private companies that borrow against this inventory and have adjustable rates, the cost of carrying this inventory right now is really becoming very burdensome as they just can’t move it quick enough. So I think this all speaks to a softening in demand into 2023 and a right sizing of inventory levels for these retailers and wholesalers.

Bill Bird:

Eddie, given that setup, is there anything you’re seeing that’s deflationary as it relates to sourcing costs and what are some of the areas that are still stubbornly inflationary in the consumer supply chain?

Eddie Hertzman:

I think we have this paradox happening and I can give you a lot of headlines that would make you feel good and then contradict them in the next sentence. For example, yes, raw material prices seem to be going down off the highs. Well, let’s not forget the floods that just happen in Pakistan, the drought that’s happening in Texas. Whenever there’s food shortages, people start to switch crops. So what happens is, yes, I think that raw material prices will go down. Obviously the freight prices are going down. I think, as John mentioned, the spot price may be lower than the contracts that people have. So all in all I would say that the cost of goods ex factory will be lower. However, once the goods hit this side, the state side, as mentioned, everything else is more expensive. The warehousing cost, the rail cost, FedEx, I think, what’s the exact rate there?

6.9% increase that they just tried to pass through. So everything is becoming more expensive as more e-commerce business penetrates the marketplace and you have more return. Everything is just showing me that the cost of operating is going up. So while the actual FOB may be flat or down, I’m not so optimistic that margins are going to ever return to a 21 level, but really return to a level that you guys want to see for a while. And there’s one other thing that I should mention, which I think is one of the most under reported headlines, is the energy crisis. If you look at countries like Bangladesh, Pakistan, Sri Lanka, these guys can’t even run their factories 24 hours a day because of the increase in energy costs. And if you look at inflation in a country like Sri Lanka, I think food costs are up 80% this year.

Energy costs are up 70%. We’re talking about people that buying a bag of rice goes from a dollar to $7, they can’t feed their family. So I think that energy costs is going to be one of the biggest factors we’re going to deal with moving into next year. From a factory perspective, what is it going to cost to run your factory? From a consumer perspective, people in Europe, the headline, heat or eat. I was talking to a colleague of mine, he has a 2,400 square foot house in Europe. His contract for that energy is $800 a month. If he did not have a contract, it would now be 4,000 a month. No one is getting pay increases to offset that type of… So this is what’s eating into people’s wallets, which is then trickling down into a lackluster demand on the fashion side.

Bill Bird:

I want to return to the structural changes going on in a moment, but first we’d be curious to hear from each of you on the Ukraine war and how you think it’s affected the supply chain from both a temporary and permanent standpoint.

John Kernan:

Well, I can kick it off real quick. Just in terms of, obviously, it’s an enormous humanitarian crisis. It’s created spiraling energy prices, spiraling food costs. It’s certainly going to make inflation stickier globally than I think we had initially thought of. And with that comes additional pressure on interest rates and the feds need to lower growth. We need to go to an above or below trend growth in the United States. That’s going to force higher unemployment, lower growth, makes for a very difficult consumer environment as we get into 2023. Costs are skyrocketing. Many of my companies have operations in Europe. The cost of operating there has skyrocketed. From what we’ve heard, supply chain costs there are moving higher because of the electricity crisis. We are staring at a very tricky inflationary environment into 2023.

John McCown:

In the container space, there hasn’t been much of a direct impact because neither Russia or Ukraine are really meaningful players in container lanes. Indirectly, of course, there’s been a pretty big effect on energy prices. Fuel is the biggest shipboard expense that’s passed on to customers in the form of a surcharge. John said, I think, the biggest impact in the container space is the impact that those energy costs and inflation are just having in worldwide economies and consumer spending in those economies.

Eddie Hertzman:

I think one of the things that wasn’t mentioned, this is not so much a supply chain response, but most brands today are global companies and Russia is a very large market. And so for the most part that’s now been shutoff, which is A, big hit to sales for people. Two, yes, you’re seeing some manufacturing in eastern Europe and places like Poland and whatnot, which has been impacted or costs, obviously, have increased. But I think these geopolitical strife that we’re seeing in Ukraine and Russia also scares me because I think China’s watching this very carefully in what could be between China and Taiwan. I don’t want to deviate into a whole other conversation, but I made a comment before that I think for a long time we’ve had global trade, we’ve taken it for granted, and I think in this past year, whether we look at the military junta in Myanmar, effectively all manufacturing has moved out of that country.

I think what, what’s left? Primark. You’re damned if you stay and you’re damned if you don’t. Ethiopia was removed from Agoa. We saw assassinations of leaders in Haiti. Peru didn’t have a president. Pakistan saw their prime minister get removed. So I just think there’s a lot of geopolitical strife and Ukraine and Russia is the big headline, but I’m concerned about international trade as a whole, and that’s just another obstacle that we’re going to have to deal with moving forward.

Bill Bird:

Jason, how about you? You’ve published some interesting stuff on how reshoring and other dynamics could impact North American transportation and logistics. Could you talk a little bit about that and what you see in your neck of the woods?

Jason Seidl:

Yeah, sure. But before we do that, let’s just talk about some of the quick things that we’ve seen of a direct impact in the here and now. So clearly the terrible war in the Ukraine has had some impacts, particularly on the bulk commodity side for a lot of my companies on the rail side. Coal demand went from dead and dying to demands through the roof right now because of what natural gas prices have been doing. So coal’s become a lot cheaper. People have thrown away the need to be completely green just to make sure that they can afford to heat their homes. So that’s number one. I think number two, on the export side, when you’re looking at a lot of the crops here in the US and in Canada, there’s going to be probably more going export than there was a year ago based on Russia and Belarus being strong on the wheat side.

Also, same thing, fertilizer. I think Russia and Belarus are one and two, or, excuse me, two and three in the world. Canada’s number one. So as it pertains to fertilizers moving out of Canada via the rail, I think that’s going to be just very, very strong demand for that. When we look at reshoring and everything else, I think that that’s going to be a very strong trend as we move out. Eddie brought up China, I think people are absolutely looking at that going, what’s going to happen to my supply chain if we have a similar situation with China and Taiwan? Especially for some of those people who are sourcing 70, 80% of their goods from China. And so I think slowly, whether it’s near shoring or reshoring, you’re going to have that happen. But remember, supply chains don’t change overnight. No one just snaps their fingers and suddenly moves factories, moves suppliers around.

It’s going to take time. But people are absolutely looking into something like that as we speak right now. The other thing I think we need to talk on is supply chain automation, because one of the things that we’ve seen with the pandemic is that shortage of labor, that still exists today as we’re talking. Labor costs are through the roof. Labor costs tend to be very sticky. We don’t see them usually go down that much, and I think people are looking to ways to save on that going forward. So I think automation in the supply chain as you look at it, whether it be longer term on the trucking side, which is probably going to come in about the next decade or so, in terms of ubiquitous fashion, or we’re talking at the warehousing front where we can lower some head count reductions, gets them increased productivity and save some money. I think that’s also going to happen.

Bill Bird:

Eddie, a little earlier, you touched on the permanence of some of these higher costs. Do you believe companies will be able to return back to 2019 gross margin levels?

Eddie Hertzman:

I’m happy you said 2019. I was afraid you were going to say 2021 and I was going to say, just no way. 2019, I’m happy you’re saying that because I think that’s a realistic benchmark that we as an industry should be using. I think what’s happening is that a lot of it’s a negative sentiment. I always like to say, being in the media space, we’re in the headline business, so good has to be great and bad has to be horrendous. What happens if we just get back, not to 2021 but to 2019? Is that such a bad state of affairs? I think it’s going to take a little bit of time, as everyone on this episode has said, has alluded to, is that costs are not really going way down and if they go way down, that’s a sign of a bigger prop, which means the man is collapsed.

I think, this year, even if holiday sales go up a little bit, margins are going to be extremely, extremely compromised. There’s a second prime day happening. Target’s already rolling out their early promotions October 6th, which is a couple weeks earlier than last year. So I think in an effort to move all this excess inventory, it’s going to be very, very promotional. Once we get through that pain and inventory levels start to go down, which we’re hopefully going to see by people ordering less, maybe we’ll have a little bit of a right sizing, and then we could start to see margins get to a level that these companies need to be at. But it’s not that these costs of goods are going to go down or the freight’s going to go down, and the rail’s going, like we said, we can’t roll back the wage increases. So the question really is, is how much pricing power do these brands have?

The retail sector we’ve seen, I’m sorry, the luxury sector, Chanel and Rolex keep raising prices that people keep lining out the door. It’s the lower end brands that served the under 55,000 household income that really are struggling. And I think that some of the increase [inaudible 00:23:16] tickets that we were seeing last year, already the off price sector starting to roll that back. These consumers just don’t have the money to absorb the higher tickets. So I think it’s something we could aspire to, but I think it’s going to take at least 12 to 18 months before we’re going to be in a position where we’re going to see that.

Jason Seidl:

Hey John, I want to interject here because it’s interesting that now you mentioned 2019, because we just got done with our 15th annual global transportation and sustainable mobility conference, and I asked every single one of the truckers and rails that were attending that about what they thought of peak season, and everyone used the term, it’s going to be a normal peak season. So they said it was going to be a decent peak season, but not like 21 or 20. It’s going to look like 2019. So I think that’s really interesting that Eddie’s bringing that up and you’re bringing it up and I think that’s really the benchmark that people should look at in terms of what to expect, at least on the freight side.

Bill Bird:

John McCown, how do you see the inflationary dynamics as you think about shipping through sea and air, and you think about the structural versus the cyclical on what we should expect going forward?

John McCown:

Yes, there’s certainly been some inflation in container shipping. I actually see a fair amount of that as going to be a structural change. Each year, on an annualized basis, we’re bringing in 29 million T use of goods. If you use the most credible aggregate pricing index, the shipping cost of those is 99.8 billion more on an annualized basis than it was before the pandemic. That costs different works out to an aggregate increase of 240%. If you compare that to the goods portion of GDP, it’s 1.82%. So it’s certainly contributed to inflation, because most of those loads move under contracts that are typically one year along, there’s a considerable tail effect even if the contracts start to reset at lower rates. But that is not yet showing up in the data. So I think we’ll see some slow printing down in overall rates, but 2023 will still be well above pre pandemic levels.

This is due both to the tail effect of those contracts and more discipline on the part of carriers regarding capacity. I anticipate more aggressive actions by carriers to cancel sailings and even cancel services in order to maintain as favorable a supply demand dynamic for them as possible. So see some of this pricing change in ocean shipping as being structural and permanent. That being said, Ed was talking about margins. The container shipping sector in second quarter of 2022 had a net income to revenue margin of 46%. That’s extraordinary by any comparison. It’s Microsoft and Apple and Fang. This is what a high margin industry looks like. Obviously those margins aren’t going to stay permanent, but I see a fundamental change in carrier behavior, and with that it’s not going to return to what was prior to the pandemic, perhaps one of the lowest performing industries. So yeah, how much of that, it’s certainly there’s a cyclical component to that, but there’s also a pretty big structural change that has occurred in container shipping.

Bill Bird:

Let’s go a layer deeper on container costs and freight rates. John McCown, can you talk about what you’re seeing from a demand perspective as it relates specifically to ocean shipping rates and how this informs your outlook for consumer spending in 2023?

John McCown:

The supply demand dynamic that sets ocean rates is starting to ease. I expect that to continue, both with the suggestion that it adds to supply and metrics showing slackening demand including shipment [inaudible 00:27:26] out of China. For the rest of the year I expect inbound loads to [inaudible 00:27:30] ports to be flat or slightly negative. This is showing up in spot rates that are well off their peaks. However, while spot rates get lots of attention, they actually only move a small minority of loads. More than 80% of the loads in container shipping move under contracts and those contract rates have continued to increase each month. That has led to seven straight quarters of record earnings for the container shipping sector with 64 billion of net income in the second quarter. I now think the second quarter will be a peak, but any talk of a bust return to anything near pre pandemic levels and rates or earnings is premature.

In container shipping there are an unusually large number of situations where narrative gets ahead of analysis. Views that 2023 will be a lot like a pre pandemic year is one example. Despite more than a threefold increase in overall container shipping rates, it’s hard to see much of an impact on consumer spending. Even at current overall rates container shipping costs represent some 6% of the average value of goods being moved. While that’s certainly higher than 2%, I’m not sure that moves the needle much in terms of consumer purchases. We saw a larger impact from the implementation of the China tariffs, yet it was hard to tease out much of an impact on consumer spending. The relative efficiency of container shipping seems to mitigate much of any volume elasticity from higher rates.

Bill Bird:

John, can you speak to container costs into 2023 and beyond? We’ve seen spot rates from China to the US West coast down almost 60% from January, but rates are still well above January 2020 levels, and at one point we increased over tenfold in 2021. What do you see ahead as you think about next year and beyond?

John McCown:

Well, spot rates are well off their peak. However, that’s just compressed the gap in their percent increase versus the more relevant contract rates. A gap still remains and the data shows there just hasn’t been the expected linkage between the two. Spot indices are determined by surveys that don’t always actually reflect actual movements. Using an average of the two most followed worldwide spot indices through today they are still up 217% since the fourth quarter of 2019, last quarter before the pandemic. Comparing those indexes to the latest definitive data on aggregate global container pricing, I peg the average percent increase in contract pricing in a range from 146% to 178%. Average contract prices have continued to increase each month throughout the pandemic, even as average spot rates have declined the last eight to 12 months. The data shows that contracts weren’t resetting at spot on the sharp ramp up.

Even if there’s a reversal in that gap, which the latest data is yet to show, I don’t expect any more correlation on the way down. Carrier behaviors change properly, permanently, in periods when there have been significant excess capacity operating, which has been most of the time I’ve known the industry. Shippers use multiple carriers and generally have the upper hand. If spot rates went below what was in the contract, the latter was often ignored. With the more active capacity management, I anticipate on the part of carriers, the contracts will have more meaning. I see the pendulum swinging more to the carriers, and with that the average rates will remain notably above what they were before the pandemic.

Bill Bird:

John McCown, is there any container volume that could come online to help increase capacity and bring down rates, and will companies permanently use more air freight?

John McCown:

The order book presently represents almost 30% terms of TEU capacity, which is an historical high. However, it is comprised mostly of larger shooks. It’s more like 15% in terms of the number of vessels. That’s still above the 10% that could be justified from physical obsolescence and historical growth rates. The higher than normal new buildings, however, won’t start showing up until the second half of 2023. While that would normally put pressure on rates, the key thing to watch here is carrier behavior that is showing more capacity discipline. Both higher than normal scrapping and canceling sailings or otherwise reducing capacity could mitigate any impact from the historically high order book.

I don’t see companies using more air freight simply because the cost remains geometrically higher than moving goods in containers. In general, moving something by air before the pandemic cost over 15 times as much as moving it by container ship. While that gap is narrowed, it still costs over 10 times as much. While the two modes are often talked about together as if they were comparable, from a volume standpoint, air hardly moves the needle. Air freight ton miles worldwide is equal to 1.4% of the ton miles moving on container ships. When you focus on direct shipping costs, air often doesn’t make much sense. The dictionary defines freight is something added to the cost of the product. In most situations, that results in using the lowest cost mode.

Bill Bird:

Interesting points. John Kernan, where is this all heading? Give us your thoughts on the future supply chain model. What do you think it looks like? How can retailers and brands lower their risk profiles? How do geopolitics affect all this?

John Kernan:

Sure. Well Ed’s earlier commentary on order cancellations of up to 30% declines paints an extremely difficult environment going into next year. This is a hard landing we’re likely to see in retail, but there’s an opportunity here for evolution. Retailers and brands need to stop chasing volume and the lowest sourcing cost in far East Asia and they need to focus on a lower risk model that promotes sustainable gross margin and free cash flow. Ed also talked about de-globalization and the risk to trade from geopolitics. It’s a real risk. We need evolution here. Working capital management is driving enormous volatility in free cash flow, gross margin and investor sentiment in the retail space. We have to stop the boom and bust cycles of inventory and gross margin.

The current supply chain model, that is proven extremely fragile and prone to disruption, needs to change. Retailers and brands have to focus on better buying, planning and allocation. They need shorter lead times with a more digitally led supply chain. Here at Cowen and Washington Research Group, we’re extremely concerned about a future conflict between China and Taiwan. This would prove catastrophic for Western companies sourcing in the Far East, given the sheer amount of materials and product that come from China and Taiwan. Taiwan supplies more materials for the athletic industry than any other country. So we need a lot of evolution here, Bill.

Eddie Hertzman:

Bill, could I add something to that? I think John, you brought up a great point about, we need to change the sourcing model. A lot of these questions that were asked today were about, are we going to see cost of goods going down? Are we going to see deflationary cost? And that really speaks to the mindset of chasing the cheapest needle. Why is the question not, how do we increase out the door prices? Out the door margin? If we saw one thing during the pandemic, it was that people lost sales because they didn’t have inventory, or how scarcity created full price sales and higher margins. What did we do? After all that learnings we went back to the exact boom and bust model that John just mentioned. We over ordered and now we’re going to go back to a highly promotional and deflationary holiday season, which is going to make it very difficult for these prices to go up again.

So I don’t know why people are not trying to reduce their calendars to four to six weeks, move closer to home, air more goods in test stuff, replenish. I’m not saying it’s a good or bad company, look at what the [inaudible 00:35:41] of the world are doing. Look at what Indy Texas has been doing for all these years. There’s business cases to be made there. There’s one other thing that we have not spoken about at all today, which is going to increase cost and putting major pressure on all these supply chains and add sustainability. I know that’s a topic you don’t want to get into, but there’s real concern that I have that as legislation starts to grow and companies don’t have a… It’s not a nice to have or a Gen Z customer wants it. But once regulation happens, and we see it in Europe with the Green Deal and other things, we see the we see Uyghur Forced Prevention Act that got past through 21st, and really was in effect before that cause of the [inaudible 00:36:20]

But if the New York Fashion Act happened, which is just the starting point for what’s going to happen in all 50 states, there’s not a single retailer I speak to. Hey John, in your conference, the Cowen conference, I actually read out loud with the New York Fashion Act entails. The whole room was silent. No one could comply and actually meet those demands. So that’s a big, big, big concern. And so the next question always everyone says, Well how expensive is sustainability? And I’m sorry, this is a question you want to ask, but there’s a major expense in sustainability, because I don’t care what survey you fill out, consumers are always going to say, Oh, I won’t pay more, but right now they’re not going to pay more. And here’s the thing, no one works for free. So every company has a chief sustainability officer, a VP of sustainability, now they have a VP of traceability.

All these roles are quite expensive. And then you need to add on the technology in order to trace your supply chain. You work with [inaudible 00:37:17] you work with Textile Genesis, Fiber Trace, [inaudible 00:37:21] DNA. That costs money. You want to work with [inaudible 00:37:25] because you need someone to benchmark your water reduction or your carbon footprint. That costs money. So all this is cost in time and money that I don’t see people really, how is anyone adding this to their balance sheets? They like to throw out their fancy 2030 commitments and their ESG reports. But what’s really going on behind the scenes is what I want to know.

John Kernan:

Yeah, Ed, here at Cowen we’ve made ESG an enormous focus on everything we do. Institutional investors are as well. And our proprietary true value scoring system enables us to dynamically score and track most material factors related to an industry and company. In retail and consumer supply chain, and materials are critical factors and we see the need for a major evolution in regards to reducing waste, circularity of products, lower levels of pollution. And Ed brought it up, the New York Fashion Act, The Uyghur Forced Labor Prevention Act. These are major pieces of regulation. There’s going to be more regulation in the future, and as Ed mentioned, none of this comes free. It’s going to come with a cost and the cost of not becoming better at ESG and not complying with regulations is catastrophic. So this is going to be a much bigger topic as it relates to supply chain going forward.

Jason Seidl:

Getting back to the ports of entry that I mentioned before, gentlemen, this is also going to impact that, right? So California obviously is one of the leaving states in terms of implementing a lot of ESG regulations, also implementing a lot of labor regulations, when you look at what’s going on with AB5, and owner operators working for companies. I think this is going to drive people away from California because all that’s going to do is decrease capacity, especially in the trucking sector. Again, I mentioned big mom and pop sector, when you look at the drayage sector, they’re not even using the new diesel vehicles, they’re using the really old crappy ones that pollute the air even more.

So when you’re looking at trucking capacity, it’s going to be scarcer out in California. The cost of doing business and pushing freight to the west coast is going to, I think, outweigh longer term stuff to the East Coast. So stuff that can go elsewhere, I think, over time, does. Now the question I have, and we haven’t been able to figure this out, is enforcement. So you’re going to get a lot of these laws in the books. I’m not so sure that we’re going to be able to enforce them right away. So I think some of these things will take time to implement through the supply chain.

John McCown:

In the container sector, with more ESG, also is going to continue what’s already been happening, but a shift eastward. If you think of the very largest grade lane in the US is obviously from Asia, very significant amount of the loads that come over the west coast then go on double stacked cranes to go part way or all the way across the country. And when you start to put the pencil to what the emissions of that is, it becomes pretty significant. And so you can look at some of the ports on the west coast, upwards of half of their cargo actually, the west coast as a way stop and it’s going across much of the country. So that shift to more all water, which has already been happening and has been going on for a while, will simply accelerate. And the good thing, I guess, from a shipper standpoint, you clearly will be adding to transit time.

It’s about eight days typically faster to go intermodal. If you look at all of that time and kind of compare it against your entire movement, when something is first ordered, it’s not as much, but eight days is eight days. But what is going to drive that even more is that, that change actually results in less economic cost. Clearly more significant reduction in emissions. And then even there’s the congestion effect. One can go through and say, well if cargo that is ultimately going to come to the east coast, moving over the west coast, going across the country on a crane with emissions and congestion problems in 15 states that have nothing to do with that. So it’s a bit of a win win win where making it all water is less economic cost and even bigger difference there. So that’s going to be a clear change with more ESG.

Eddie Hertzman:

I just want to caution that this industry is a very reactive industry. Proactive is not a word I even think that’s in the vocabulary of any boardroom. And yes, you make a good point. How much are they going to be able to enforce or how long is it going to take? That is, for anyone listening, I want them to close their ears and not even think about that. Because that is the wrong way to think about how to address these problems. I’m not on the hill, I’m not a lobbyist, but everyone that I speak to says that customs will be putting more resources behind stopping these containers and enforcing the The Uyghur Forced Prevention Act. And I think that people think this is a China only problem. It’s nothing to do with China in particular. You come from anywhere in the world, they’re stopping shipments from Bangladesh, they’re stopping shipments from anywhere.

And you not only need to prove where the origin of the raw materials are, but also who is making it. So just because the raw material’s coming from a safe place, if you ship it to a factory that is questionable, you have a problem there. But this is just the beginning of a larger problem, because I lead to questions, when you’re on the investor calls, when you’re speaking to management, ask them can they trace their supply chain? I guarantee you nine out 10 or 9.9 out of 10 are going to say no. And so the question is, if the container gets stopped, I don’t know anyone that could get it through. So if you’ve got a big holiday shipment that hits the port, it’s complete loss of [inaudible 00:43:20] and all the money they spent is gone. This is a huge risk. And you can’t just say… This is not Vegas. We can’t play roulette here. We have to have procedures in place, not react to it because by the time the container gets stopped, it’s already too late.

Jason Seidl:

One of the things about stopping containers and everything else, obviously there’s a lot of China tarrifs have been circumvented or people have been trying to circumvent it by bringing stuff in through Mexico. So that’s one of the things that we’ve seen some of the freight move around, come up in through Mexico into the US. In terms of enforcement, Eddie, I think I was more referring to the AB5 rule. I think enforcement of that’s going to be a little bit more difficult. It’s really something right now that I don’t think we’re fully prepared for. Especially when you look at AB5 and moving beyond California, which I think is a distinct possibility as we look out into 2023 and beyond.

Eddie Hertzman:

Jason, you talk about Mexico, so many people have open bonded warehouses in Mexico and Canada take advantage of de minimus, and de minimus is become such a legal loophole in terms of custom savings. But there are people in Washington that are making it their job to try to roll this back. And I’m not saying for sure it’s going to happen, but it is on the table. And if that does happen, which [inaudible 00:44:41] imports four billions of dollars, that’s probably a billions in duty savings. So that’s really alarmed to everybody. But how many companies are taking advantage of this? And if they were to now have to pay duty on that direct to consumer shipments, we have millions if not billions of new costs hitting their P and L that they’re not prepared for. So it’s not that it’s going to happen necessarily, but it’s public and it’s out there that there are some legislators that would like to roll this back. Whether that means 800 back to 200 or get rid of it all together. It’s just another little red flag that I think we got to keep our eye out on.

Jason Seidl:

Well, I think that’s something that we should be looking for at the Washington Research Group here at Cowen. I’m sure they have their ears to the ground on that. That’ll be interesting.

Bill Bird:

Well, gentlemen, you have been very generous with your time. This has been just an absolutely great discussion and I have a feeling we could go for another hour and uncover many, many more insights. So we look forward to doing another one of these with you at some point in the future. Why don’t I send it over to John to wrap things up. But thanks again everybody, this was terrific.

John Kernan:

Yeah, I echo Bill’s thoughts. This is tremendous content. It gives us all much to think about as we think about our industries and models next year. And I’m so thankful for John, Jason, Ed and Bill’s time. To our listeners, please reach out if you have any questions. We hope to hear from you all soon. Please stay tuned for our next State of the Consumer podcast in coming months.

Speaker 1:

Thanks for joining us. Stay tuned for the next episode of Cowen Insights.


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